It is my pleasure to report results for Alluvial Fund, LP’s first six months of existence. While such a period of time is insignificant in the grander scheme, I am nonetheless happy to see the value of our investment grow at a healthy clip out of the gate. For the three months ended June 30, 2017, the value of an investment in Alluvial Fund, LP rose 7.1%, net of full fees. This compares favorably to the S&P 500 Index total return of 3.1% and the Russell 2000 Index total return of 2.5%. Year-to-date, Alluvial Fund, LP has produced a net return of 12.6% compared to 9.3% for the S&P 500 and 5.0% for the Russell 2000. The partnership finished the quarter with $9.3 million in assets.
In launching the partnership, Alluvial has welcomed several new limited partners. I am grateful for the opportunity to manage capital for you, and I will work to the fullest of my abilities to maximize the value of our investment. I am equally grateful to those partners who took a risk on a young, wholly unproven manager back in 2014, when Alluvial was born from a blog I would update in the wee hours in my rowhouse apartment on Pittsburgh’s North Side. It’s been incredibly rewarding to see both our portfolios and the scope of Alluvial’s activities grow.
These quarterly letters are a medium for me to discuss meaningful events at portfolio companies and lay out the investment case for various holdings. From time to time, I may share some general investment-related thoughts. However, I tend to leave the pontificating on value investing to others. I enjoy talking about the opportunities I have found much more.
With that said, let’s get to it. Alluvial focuses on small companies, illiquid securities, and special situations. Though we maintain this focus, we will purchase larger and more liquid securities when they are especially misprice. We invest globally and are willing to wait years for value to be realized, provided value is accruing at a reasonable rate in the interim. When thinking about Alluvial Fund’s various holdings, I divide them into four informal categories. Many Alluvial holdings do not fit neatly into any of these categories, but the categories do provide me with an analytical framework I use in evaluating possible investments.
1. “True Growth” Companies
Any company that has access to additional capital can grow its revenues and earnings. Whether or not this actually increases intrinsic value depends on the rate of return achieved on the additional capital deployed. While many firms waste investor capital on dubious acquisitions and initiatives, there are companies that have the ability to deploy significant additional capital at attractive rates of return. Through reinvesting internally generate cash flows and tapping capital markets judiciously, these firms can grow their earnings and free cash flow at double-digit rates for years on end, creating incredible shareholder wealth in the process. There is a word for these types of companies that some like to use, “compounders.” That word makes me mildly queasy because in present usage, a “compounder” seems to be any company with a reasonable return on invested capital and a share price that just keeps going up. History shows what eventually happens to the share prices of companies like these when commensurate economic value is not being produced. So, I prefer my own terminology. In practice, these “true growth” companies are rare in public markets. The best never go public at all, having little need for external capital. Or, when the market catches wind of the superior economics on offer, a larger firm quickly swoops in with an acquisition offer. Large firms are ever hungry for growth.
Examples of these companies in Alluvial Fund’s portfolio include Meritage Hospitality and Scandic Hotels. Meritage, which I have written about several times in past letters, is extraordinarily adept at purchasing run-down Wendy’s units from motivated sellers. Once renovated, unit sales soar and thanks to Meritage’s centralized purchasing and scheduling systems, so do operating margins. Meritage has added units at a rapid pace over the last decade and now has 249 units, with a goal of owning 400 within four years. The company has the managerial talent, access to capital, and the support of Wendy’s corporate to accomplish this goal. Insiders control the large majority of Meritage’s common and convertible preferred shares, and Alluvial is one of the largest outside shareholders.
Scandic Hotels is a rather new holding, but has an intriguing business model. In the US, a typical hotelier purchases a property by borrowing 60-70% of the purchase price. This model’s fixed costs are high because of interest and principal paydown requirements, but so are the rewards if hotel occupancy and room rates remain strong. In Scandinavia, the industry works a little differently. Rather than purchase properties using mortgage financing, hotel operators sign long-term leases with hotel owners. These leases include both a fixed annual rent component and a royalty on the gross revenue the hotel generates. This model limits the hotel operator’s upside somewhat, but also reduces risk in difficult operating environments as lease expenses decrease along with hotel revenue. In addition, property owners are incentivized to work with hotel operators to keep properties in top condition and maximize their lease earnings.
Scandic takes full advantage of this operating model. The company can add rooms to its network at a rapid pace because nearly no upfront capital is required. At year-end, the company offered over 40,000 rooms and had nearly 5,000 in its pipeline to add in 2017 and 2018. As long as the company is successful in filling these rooms, profits will follow. But Scandic’s business model possesses one more very attractive feature. It generates float! The majority of Scandic’s hotels are basic but comfortable, and Scandic has an extensive presence in mid-sized and smaller cities. This makes them perfect for corporate travel, and indeed Scandic operates a loyalty program for business travelers and others. This results in a lot of prepaid revenue. And I do mean a lot. In 2016, Scandic Hotels earned SEK 879 million, but negative working capital investment added another SEK 150 million to operating cash flow. The amount of float that Scandic adds varies from year to year, but will remain positive as long as the company continues to expand its hotel network.
When investing in a company like Meritage Hospitality or Scandic Hotels, Alluvial’s intent is to be a very long-term owner and enjoy the exponential increase in value that such companies often produces. However, I am not oblivious to the fact that in a market economy, economic moats are constantly under attack and can vanish. Should these companies lose their ability to earn excess profits or their values